Tuesday, June 28, 2005

Where’s Inflation? Ask Del Monte

Everybody knows prices of things are rising. At least, everybody but the bond market, which appears to believe the accuracy of the inflation numbers compiled by the government and reported in various indices which, for the moment, show nothing much is going on in the world of consumer prices.

This despite the fact that pretty much every commodity coveted either by homebuilders in the United States or manufacturers in China has been on a tear the last couple of years.

Still, as Jay Fitzsimmons (who is not Wal-Mart’s CFO, as careful readers noted when I identified him thusly in last week’s post on Russia, but is, rather, Wal-Mart’s Senior Vice President of Finance and Treasurer) noted during his question-and-answer session at the William Blair conference, inflation at Wal-Mart stores is pretty tame.

Food inflation, Jay said, is running 1.8-1.9%; general merchandise deflation is about 1.3%; net-net, “there’s not much” inflation that Wal-Mart can see.

Still, anybody who eats food, drives a car, heats a house, pays rent, stays in a hotel, books a vacation, buys a newspaper and pays property taxes knows, costs of things are in fact rising.

So where are all those costs going?

To answer that question, look no further than the transcript of the recent Del Monte Foods conference call.

Del Monte does food—very basic food: canned fruits and vegetables under its own name, as well as StarKist tuna, 9-lives pet food and some other cats and dogs-type businesses.

The company was shmooshed together via a reverse merger with Heinz’s bad-for-our-P/E-Ratio StarKist tuna business a few years ago, and the ensuing equity roadshow presented a fairly compelling case of good management revitalizing long-neglected brands with strong cash flows underlying the whole smorgasbord.

Then, something happened that was not anticipated during the roadshow: costs went up and Del Monte’s earnings and stock price went down.

More specifically, according to Del Monte, it was “the rapid and unprecedented cost escalation in steel, energy and transportation-related costs, which, combined, represent about 40% of our costs of goods sold,” that hurt the company. “These increases, along with higher fish and other costs, resulted in year-over-year cost increases of over $120 million in fiscal 2005…”

Del Monte did what it could to offset the cost increases by raising prices to the tune of around $90 million a year. But Del Monte’s customers did not entirely go along with that idea, so Del Monte lost market share at the likes of, well, Wal-Mart for one.

“Let me just give you a range of some cost increases we’re anticipating,” the Del Monte CFO told disappointed analysts last week. “We’re anticipating packaging costs to [increase] $30 to $35 million. We’re looking at energy and logistics to [increase] $25 to $35 million. We’re looking at raw materials to [increase] $15 to $20 million.”Asked if the “raw materials” portion was just fish costs, or “a whole bunch of different stuff” by one of the analysts, the CFO responded: “That’s a whole bunch of different stuff, including fish costs.”

If you’ve never heard Len Teitelbaum, the veteran Merrill Lynch food analyst, on a conference call, you should try to listen in some time. Lenny, as everyone in the world knows him (our paths crossed at Mother Merrill 20+ years ago, but he would not know me from a can of tomatoes), possesses great enthusiasm for his work and his companies, and he knows just about everything there is to know about the food industry.

But when something goes wrong, Lenny sputters—he can barely get the words out to ask the questions; and yet he will not stop until he has asked the questions and gotten the answers he wants.

And on last week’s Del Monte call, Lenny was sputtering. As is Del Monte’s own business.

Blame it on inflation—inflation for “a whole bunch of different stuff, including fish”—and Del Monte’s inability to get Wal-Mart to pass it all on.

Jeff MatthewsI Am Not Making This Up

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations.

9 comments:

And as Warren Buffett said at his annual meeting, " with the inflation we're seeing with our privately held co's, I cannot explain 4% on a 10 yr bond". And furthermore, Buffett is continueing to raise funds issueing notes ( like he doesn't have any cash left LOL ) to take advantage of whats cheap - money.

But the point is these things are not being passed through to the consumer. The producer who has less power than Wal-Mart is eating it. That is what I have heard on calls and that is what I see to a large extent in your piece. I think Jay's overstating things a little on food inflation as I think Wal-Mart is taking 30-50 bps of price, but it's close enough. In any case, bottom line, the food business isn't such a great place to be these days.

I think you're missing the point. The question is not whether the cost increases are successfully passed on all the way to the consumer level -- it is simply that when someeone, anyone in the chain has to absorb the the higher costs without being able to raise their prices...well, that somebody's earnings suffer.

This isn't simply a discussion of the food industry, nor is a consideration of whether the consumer feels the pinch. Rather, the key point is that higher cost of goods manufactured coupled with a lack of pricing power makes for a profit-shattering situation for a certain companies.

Which companies are impacted? Well, only those that who transport their products from one point to another. And only those who manufacture products requiring materials. Or those who travel. Or those. Or those who require additional real estate. Or those who...

You see, the question -- for many who are readers in this forum -- is not "Will I personally pay 5 cents more for my canned peaches at Wal-Mart?" Instead the question is about coroporate earnings and stock valuations. If companies' earnings are going to grow less because of lack of pricing power for their goods, then the stock market will penalize them via lower earnings multiples and consequently lower stock prices. That's the way it works. So for those who are market participants, this becomes a very important issue.

Unknown,The point as I understand it was encapsulated in the opening paragraph:

Everybody knows prices of things are rising. At least, everybody but the bond market, which appears to believe the accuracy of the inflation numbers compiled by the government and reported in various indices which, for the moment, show nothing much is going on in the world of consumer prices.

I have trouble believing one of the world's largest, most liquid, and more competitive markets misses something as basic as the level of inflation in the system, but that's another issue. The point being made by Jeff, though, is there is inflation in consumer prices and here's one example. My point is that this is not an example because cost inflation is being sucked up by Del Monte and not ultimately the consumer. I don't know if Jeff's point was as you state it.

I think this is actually a very good example of the strategic shift in consumer products and retailing in the last 20 years. 20 years ago, manufacturers were king. Branded products in many cases generated ridiculously supernormal profits. Now that we have a much bigger retailer between us and these companies, the cost doesn't get pushed on as quickly. If inflation in the intermediate step is sustained, then it will probably come through at some point. But in the short term, there's little pass-through and the branded consumer companies have to eat it because they're not as well positioned strategically as they once were.

So I'm not sure if your point and my point differed too much. I'm pretty sure Jeff had a different point, but all of this gets me back to my original close. Food is a bad place to be, especially on a sub-sector basis in consumer land.

I think the point is that while these producers might be eating their cost at the moment while they figure out what to do at some point many producers will either figure out a way to raise prices on consumers or they many will be forced to consolidate or leave the business as profits are cut down by their inability to raise prices. The other option is of course to increase efficiencies but how many cost do you really think are left to cut today. I think the point is that people buying stocks or bonds today expecting low inflation are mistaken and might get burned in the medium to long run. The only catch at least in my opinion is that if there is an economic downturn, something that doesn’t look at of the question with our macro problems and governmental policies, then long bonds will have proved to be an ok buy.

while they figure out what to do at some point many producers will either figure out a way to raise prices on consumers

They can't do this. They don't control the customer interface.

any will be forced to consolidate or leave the business as profits are cut down by their inability to raise prices.

Agreed. Thought it may take more erosion of returns in the consumer packaged goods space to get there. When you look at the structure of non-US food and staples retail, the packaged goods/food/beverage industry is still in for lots more pain. Look at General Mills the other day. Sure, they raised prices, and they got smacked for it. Consumers either substituted, went private label, retailers took away shelf space, or the companies had to up promotional allowances. Any way you cut it, pricing to make up for the transport costs and higher packaging did not work that well.

The other option is of course to increase efficiencies but how many cost do you really think are left to cut today

Not too many -- these are highly optimized businesses. You can combine to gain market power vs. your customers and cut out white collar people, but that's about it, I think.

I think the point is that people buying stocks or bonds today expecting low inflation are mistaken and might get burned in the medium to long run.

If they are mistaken, should't you say they will get burned instead of suggesting they might get burned? I dunno, I'm not an asset allocator, so I'm not trying to figure out this question. I'm a plain vanilla mainly long-only equity guy.

The only catch at least in my opinion is that if there is an economic downturn, something that doesn’t look at of the question with our macro problems and governmental policies, then long bonds will have proved to be an ok buy.

Well, given how many people think the macro environment is horrible, there's a financial blowup on the way, consumers are over-levered, etc. etc., maybe this is why the bond market is betting this way.